What is Financial Instrument Risk?
Buyers and sellers may enter into sub-optimal financial or commodity instrument structures that have been standardized for efficient electronic trading. Conversely, buyers and sellers may enter into transactions where some trade terms were not anticipated due to shortcomings in the electronic communication means portraying the transaction.
Formally, a financial instrument is cash, evidence of an ownership interest in equity, or a contract that is both:
- A recognized or unrecognized contractual right of one entity to:
- Receive cash or another financial instrument from another entity
- Exchange other financial instruments on potentially favorable terms with another entity
- A recognized or unrecognized contractual obligation of another entity to:
- Deliver cash or another financial instrument to another entity
- Exchange financial instruments on potentially unfavorable terms with another entity
The financial instruments used in electronic trading will be the same financial instruments traded in the broker market today (e.g., swaps, options). These instruments are standardized in their function, but the counterparties customize the instruments’ structure. Swaps involve the exchange of revenue streams between parties, typically without any premiums paid. Options (e.g., puts and calls) give the buyer the right, but not the obligation, to exercise the option for the payment of a premium to the seller who is called the option writer.
The types of financial instruments include:
- Debt securities: Financial obligations representing a right to be paid money which includes a deposit
- Equity securities: Shares of the capital stock of a corporation or any interest in or right to such a share
- Insurance policies
- Interests in a partnership, trust or estate of a deceased individual, or any right in respect of such an interest
- Precious metals
- Options or contracts for the future supply of a commodity, where the option or contract is traded on a recognized commodity exchange
- Guarantees: Undertakings to pay money or perform obligations with respect to another financial instrument
- Options or contracts for the future supply of money
Due to the over-the-counter (OTC) transactions of these financial instruments, there are no standardized agreements or controls that exist with established exchanges (NYMEX). Consequently, credit limits and approvals between the parties, as well as enabling agreements, must be completed through the electronic trading platform. Populating the system with qualified buyers and sellers can be a challenge.
Financial Instruments in Traditional Broker Trading
With all trading of financial instruments, both electronic and brokered, there are a number of important risks to consider:
- Credit Risk: The risk that a party within the system will be unable to fully meet its financial obligations within the system currently or at any time in the future
- Market Risk: The risk to an institution’s financial condition resulting from adverse price or volatility moves of the assets contained in a firm’s portfolio
- Liquidity Risk: The risk that a party within the system will have insufficient funds to meet financial obligations within the system as and when expected, although it may be able to do so at some time in the future
- Legal Risk: The risk that a poor legal framework or legal uncertainties will cause or exacerbate credit or liquidity risks
- Operational Risk: The risk that operational factors such as technical malfunctions or operational mistakes will cause or exacerbate credit or liquidity risks
Questions to Consider
- Will the underlying commodity locations, which are used for settlement pricing, be exhaustively listed by the digital market?
- Can options be effectively traded today on digital markets due to the level of volatility that exists in the bids/offers pricing?
- Updating of bid and offer on a real-time system
- Time stamping accuracy for quotes
- Difficulties in customizing options electronically
- What are the policies and procedures for trading non-standard instruments?
- How does financial settlement mirror physical settlement?
- Is financial trading more profitable than physical trading for digital markets?
- How are the trading rules specified so that they are consistent with physical supply chain constraints?
- Are there any guidelines for the structure of exotic (non-standard) commodities?
- How are alternative financial instrument structures presented?
This information was taken from KnowledgeLeader’s benchmarking tool Financial Instrument Risk Key Performance Indicators.
- Financial Instruments in Electronic Trading: Not every instrument and every type of trade is equally suitable for trading on a centralized electronic trading market. This tool lists conditions that indicate a transaction is less suited for trading on a centralized electronic trading market.
- Financial Instrument Electronic Trading Methods: In electronic trading, all aspects of a trade run through an electronic pipeline.
- Business Risks Related to Financial Instruments: This tool lists the potatntial impact of failing to manage financial instrument risk.
- Stay abreast of changes in financing rules and regulations as well as opportunities available through new financing tools.
- Get in on the ground floor of new financial instruments.
- Understand the Inherent risks of the financial instruments selected.
- Select an investment bank based on its understanding of both the company's funding needs and its knowledge of current investor demand.
Here are some additional tools on KnowledgeLeader related to this topic: